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INVESTING: MAKING YOUR DOLLARS WORK FOR YOUA GUIDE TO INVESTING IN PETROLEUM MARKETS
The price of a barrel of oil is mentioned each day on every news
program. It has almost become an economic indicator of sorts.
We've all seen that several of the billionaires in the world reached
that milestone through oil businesses or investments. Obviously,
there is a lot of upside to getting involved.
If petroleum markets are confusing to you, you’re not alone: bothindividual investors and most professionals fi nd them perplexing.
Why does the price fluctuate so much on a daily basis? We're going
to attempt to understand the market forces at work and how to
invest in petroleum related entities.
Price Influencers
1. Demand. Just like you learned in high school economics class,demand has a significant impact on price. The daily demand for
oil is around 85-90 million barrels per day. While the demand in
the United States does drop to some extent when prices rise, in
many emerging markets, the demand doesn’t drop noticeably.
‣ The demand in these emerging markets is only expected to
increase over time. In fact, in many of these countries, there
are subsidies for consumers. Approximately 25% of the
demand for oil is from countries with subsidies in place.
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‣ Unfortunately, these subsidies can actually hurt that
country's local oil production. This results in less supply,
which only serves to increase demand and the price of abarrel of oil. Removing the subsidies can increase local
production by allowing smaller, local refiners get a more
competitive price.
2. Supply. The supply tends to match the demand side quite
closely. Most of the largest oil producers don’t have the ability
to pump significantly more oil. Saudi Arabia is usually the only
exception.
‣ Nigeria has a lot of capacity, but the political instability
makes the supply of oil from here unstable. Even the
off shore rigs are attacked from time to time. The lack of
stability on the supply side can cause price fl uctuations.
3. Quality. As environmental regulations increase, the quality of
crude oil is becoming more important. This higher quality oil is
frequently referred to as "sweet" crude. Much of this oil comes
from Nigeria and the surrounding region. Recently, the US has
imported more oil from Nigeria and Angola than from Saudi
Arabia.
‣ This issue of crude quality is likely to have even more
impact in the future.
4. Speculation. Speculation has possibly become a major factor in
the price of oil. Large institutional investors have become very
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active in investing in oil futures contracts. While many experts
believe that these activities have only a minimal eff ect on the
price of oil, others believe they have a significant eff ect.
‣ It’s possible that speculation is largely responsible for the
large increase in the price of oil, and consequently, gasoline
over the last 10 years.
Investing Options
Regardless of the reasons for the price fluctuations, there are
several options for those who want to profit from the oil industry.
Let's take a look at your choices.
1. Oil Stocks. Oil exploration, drilling and service, and refining
companies off er a simple way for the typical investor to become
involved in the industry. These companies off er exposure to the
industry other than the obvious (Exxon, Mobil, and more):
‣ Exploration and Production Companies (E&P). These firms
find petroleum reservoirs, drill wells, get the raw materials
out of the ground, and then sell them to refining companies.
There are hundreds of these companies on the US stock
exchange. Understanding oil production basics is important
if you're going to invest here.
‣ Drilling and Service. The E&P companies typically do not
have their own drilling equipment or the staff to run it.
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- Drilling companies are hired to drill the well and get
everything in place so the material can be removed from
the ground. These companies are paid for their time, not
for the amount of production that results.
- Service companies are hired to maintain and service the
wells. The revenue of these companies is largely tied to
the number of active wells they’re servicing at any time.
‣ Refining Companies. These companies take the raw crude
oil and refine it into diesel fuel, gasoline, heating oil,
kerosene, and other products. While the previous types of
companies are considered to be the upstream part of the
industry, refining companies are on the downstream side.
2. Sector Mutual Funds. These mutual funds specialize in all
things energy related. You can find a fund that invests in the
types of companies that interest you in accordance with your
risk tolerance.
3. Exchange-Traded Funds. If you're interested in more exposure
to the price fluctuations of oil, these are ways to invest in oil
futures without having a futures account. Oil stocks and
related mutual funds are not heavily correlated with daily price
fluctuations of oil.
‣ You have many options here, from investments in oil only to
investments that cover several products (oil, heating oil,
gasoline, and more).
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‣ For example, if you own one share of U.S. Oil Fund ETF
(AMEX:USO), you would own approximately the equivalent of
one barrel of oil. If the price of oil rises 10%, you would make10% if you sold that share. There are brokerage fees and
management fees to deal with as well.
‣ While you don't have to do anything other than buy and sell
the shares, these investments are quite complex for the
management teams running these funds. It would be wise to
learn as much as you can.
‣ Understand that the primary way these funds invest is
through futures contracts. This essentially means that these
funds are betting on what the price of oil will be at some
future date in the future.
Conclusion
There are a variety of ways to invest in the petroleum market.
Stocks and mutual funds provide exposure that is relatively
sheltered from the daily fluctuations in the price of petroleum
products. Exchange-traded funds off er the short-term investor a
lot of exposure to those same price fluctuations.
Those with the nerve to go it alone can invest in futures on their
own. Always remember that any investment vehicle that o ff ers
the opportunity to make a large amount of money in a short
period of time also typically o ff ers the opportunity to lose money
quickly. Educate yourself before taking the plunge.
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